Why Even Bond Managers Hate Bonds

It may be time to switch back to stocks.

Anyone who has been paying attention these past few years knows that bonds have been the go-to investment by a wide margin. Billions and billions of dollars found their way from stocks and stock funds into the fixed-income market. The calls for caution and warnings that investors were chasing returns came from many quarters, but investors seemed content to park their money in the perceived safety of bonds. But now even the folks who invest in fixed-income instruments for a living appear to be taking a step back from bonds.

Stocks are the new bondsWhen it comes to bond investing, there are few luminaries more celebrated than Bill Gross. Thanks to investors' recent love affair with bonds, Gross's Pimco Total Return Fund (PTTAX) now ranks as the single largest mutual fund in existence, with more than $250 billion in assets. And with his decades of fixed-income investment experience, where does Gross see the greatest opportunities in the coming years? Well, in stocks.

According to a regulatory filing made this month, Pimco Total Return is expanding its mandate. Starting early next year, the fund will be able to invest up to 10% of assets in convertible securities, preferred stock, and other hybrid debt-equity instruments. While such a move probably won't significantly alter the fund's overall profile right away, it is pretty notable when a fund that has earned top marks investing one way for decades changes course a bit and starts fishing in a different pond.

Shifting windsThis shift has broad implications for shareholders of Pimco Total Return. While allowing up to 10% of equity-related investments in the fund probably won't crank up portfolio risk to an excessive level, it means that the fund will look slightly different going forward. Investors who bought this fund expecting a pure bond play should realize that they will be getting some equity exposure on the side. That means volatility could be higher here in the coming years.

However, I would be willing to bet that this won't be the last bond fund that quietly adjusts its mandate to allow a larger equity allocation. Investors should make a point of checking in with their bond funds to see if they have recently changed their allowable investing universe or if they have plans to do so. If you're not comfortable with a bond fund that has the recently acquired freedom to hold a hefty chunk of assets in stocks, you may want to think about moving to a bond index fund or exchange-traded fund. iShares Lehman Aggregate Bond ETF(NYSE: AGG) or Vanguard Total Bond Market ETF(NYSE: BND) both dedicate themselves completely to bond market coverage.

But looking at the bigger picture, if investors were in need of further proof that the bond market is overbought, this is it. Gross has repeatedly stated that the roughly 30-year bull market in bonds is likely ending and that investors will need to adjust to that reality. Few would quibble with the returns that bonds have generated in recent history, but those who think the next decade will bring equally impressive results are kidding themselves. If you want your portfolio to grow over the coming years, you've got to shake off your fear of the last bear market rout and get some more money into the stock market. Investors may finally be getting this message, as the years-long flow of money into bond funds appears to be reversing -- roughly $8.6 billion was withdrawn from bond funds in the week ending Dec. 15 alone.

Get back in the gameIf you were among the scores of investors who abandoned the equity market in favor of bonds, the time has come to put some of that money back to work. Folks in or close to retirement still need to keep a majority of their assets in fixed income and cash, but those of us with a longer path to retirement should be loading up on stocks right now. And while dividend-producing names are getting a lot of attention right now, there are other areas of the market that are ripe for the picking.

For example, the folks over at Dodge & Cox are big into the information technology arena, a sector that I think should outperform in the coming quarters as the economy firms up. Their top-ranked Dodge & Cox Stock Fund (DODGX) is pretty heavy into the tech sector, to the tune of 21% of assets right now. Hewlett-Packard(NYSE: HPQ) is the fund's biggest bet, as management sees great opportunities in the company's strong cash flow, healthy balance sheet, extensive R&D investments, intellectual property assets, and generally reasonable valuation. Media stocks also play a heavy role here -- with Comcast(Nasdaq: CMCSA), Time Warner(NYSE: TWX), and News Corporation(Nasdaq: NWS) all sporting earnings multiples of 18 or less, which look attractive relative to future growth prospects as forecasted by fund management.

While all investors should have at least a minimal exposure to bonds, stocks are hands-on favorites to create the most value in the years ahead. Bond investors should be cautious, as it probably won't take much for outflows to accelerate and cause a bit of a panic, really roiling the bond market. Investors have likely milked most of the excess gains out of this sector that they can. It's time to move on to greener pastures.